Written evidence from the Cardano Group LDI0034

Introduction and overview

Cardano is a privately-owned investment management and advisory business with a focus on risk and sustainability. Our advisory business serves approximately 400 scheme and corporate clients, our investment management and fiduciary management business has £50bn AUM as at 31 December 2021, and we manage over £15bn in DC across the UK and the Netherlands.

As investment and covenant advisers and fiduciary managers, with a focus on securing better, resilient, and more sustainable financial outcomes for savers, employers and wider society, we are pleased to respond to this Work and Pensions Select Committee inquiry. 

Our response in this document can be summarised as follows:

-                      The LDI and Gilt markets experienced an acute and highly idiosyncratic stress and liquidity event beyond that of any reasonable scenario test. Financial regulators and market participants came together to limit the impact on pension schemes. The experience across schemes differed depending on the structure of their investments and level of governance. In general, schemes were prudently managed however there were outliers whose funding levels have been materially impacted.

-                      LDI has served as an invaluable tool for pension schemes and their sponsoring companies over the last twenty years resulting in schemes with stronger funding levels and lower dependencies on their sponsoring company. 

-                      Given the widespread use of leveraged LDI strategies within the pension fund industry, the level of bonds held by pension schemes is at a significant level relative to the size of the Gilt market. A key policy decision is required to balance the benefits of a leveraged LDI market and the vulnerability to the Gilt market it introduces.

This response is provided on behalf of the Cardano Group. We confirm we are happy for our response to be made publicly available.

We hope that our response to the call for evidence proves useful. We would be more than happy to discuss any of our thoughts in more detail.

In response to the Work and Pensions Select Committee’s call for evidence and each of the questions outlined, please see Cardano’s views below.

The impact on DB schemes of the rise in gilt yields in late September and early October

The size and speed of interest rate moves in late September and early October resulted in pension schemes needing liquidity to collateralise their LDI strategies over a short time scale. This resulted in schemes needing to raise capital quickly and where this was not possible, reducing the interest rate and inflation hedge.

The ability to raise capital quickly varied across schemes and was dependent on the type of LDI strategy and the governance structure in place.

-                      Clients with segregated or bespoke-pooled LDI arrangements in general were better able to provide the required collateral than those with multi-client pooled LDI strategies. The multi-client pooled fund structure was limited by trading and settlement windows and the resource requirements needed at the investment management firms to manage the volume of schemes requiring capital.

-                      Schemes with higher leverage levels or higher levels of illiquid assets, for example those who had previously participated in buy-in transactions, had more challenges redeploying capital to the LDI strategy.

-                      Schemes with strong advisory, fiduciary management or trustee governance structures in place were better equipped to react than those that did not.

There were a number of immediate consequences facing schemes as a result of redeploying assets to the LDI mandate.

-                      Schemes’ target asset allocations and risk-return targets have been disrupted. 

-                      Where assets were sold to provide additional collateral, transaction costs were incurred and in some cases assets were sold at reduced prices (for example where schemes sold credit assets following large falls in their price) or haircuts were incurred (for example where schemes were forced to sell private assets).

Where schemes reduced their interest rate and inflation hedge levels, they have been (more) exposed to the subsequent move in interest rates. The schemes’ funding level could have been affected depending on the level at which the hedge was reduced and subsequently reinstated.

-                      The majority of schemes were able to manage their hedge in a controlled way. In these cases, we don’t expect schemes funding levels to have materially changed. We expect an impact on funding levels of circa 1-4%.

-                      The exceptions are schemes whose hedges were reduced, either by the fund manager taking action or due to the lack of available collateral, at the highest levels of interest rates prior to the Bank of England intervention. Here, funding levels may have been materially impacted.

Schemes will now need to reassess their journey plan to full funding in line with their revised circumstances. As part of this, we expect schemes will revise the level of collateral required to support their LDI arrangements. In a regime where larger collateral buffers are held, schemes will not be able to hedge as much of their interest rate and inflation sensitivity whilst maintaining the same return target. A reassessment of the risk and return targets and therefore journey plans will be required. All else equal this will result in a longer or more volatile period for schemes to reach their target funding levels. This could also put strain on sponsoring employers who may need to pay in additional contributions directly as a result of the market stress.

The impact on pension savers, whether in DB or defined contribution pension arrangements

Given the short window of the market dislocation and the subsequent retracement of yields, most defined benefit (DB) and defined contribution (DC) savers were not materially impacted by the event. The future obligations to DB savers are however dependent on their scheme’s future funding level to the extent that an individual scheme’s funding level was materially impacted.

Under the UK DB pension system, pensions are paid to individual members by the scheme which is in turn backed by the sponsoring company. We are not aware that the impact of the increases in Gilt yields in late September and early October resulted in any schemes being unable to pay individual member benefits or resulted in any sponsoring company not being able to meet its future obligations to the scheme.

UK DB savers are however beholden to their pension scheme to pay their pensions into the future as they fall due (unless the liabilities are transferred to a third party as part of a pension risk transfer arrangement, or the member withdraws their assets from the scheme). As such, DB pension savers are interested in the future health of the scheme for the continuation of their benefits. Where scheme funding levels have been detrimentally impacted as a result of the yield moves, the certainty of the DB savers’ future pension payments has deteriorated.

DC savers will have been impacted over the period through the significant movement in asset prices. The impact will have been more acute for savers holding a higher proportion of UK government and corporate bonds; in general, this will be savers closer to retirement.

But, given the subsequent retracement in yields, DC savers who did not sell assets during this period will not have been materially affected. DC savers seeking to buy an annuity will have seen a fall in annuity prices due to the increase in yields.

The recent events as well as the sensationalised press articles surrounding the events may lead to decreased confidence of savers in the UK pension system. We note the importance of restoring confidence in the system to ensure savers continue to invest in their DB or DC pension arrangements.

Given its responsibility for regulating workplace pensions, whether The Pensions Regulator has taken the right approach to regulating the use of LDI and had the right monitoring arrangements

Given the impact of the yield rises in September and October on the pension system and the Gilt market, we believe there is a good case for reviewing the regulation and monitoring arrangements in place.

Any subsequent regulation and monitoring should primarily be focussed either on the protection of pension schemes and their savers, or on the orderly functioning of the Gilt market. 

For any pension scheme focused regulation, we note the experience across pension schemes was not uniform and depended on the type of LDI arrangement and the governance model in place. Most schemes had prudent levels of leverage and were not materially impacted. There were however schemes that were materially impacted due to a disorderly unwind of their LDI hedge. Hence, a one size fits all approach is not suitable and the review should take into account the type of LDI arrangement and the liquidity of the collateral assets it can call on, the governance model and the strength of the sponsor covenant. It would be appropriate for The Pensions Regulator to opine on the regulation.

If the primary concern is the orderly functioning of the Gilt market, it would be appropriate for the Bank of England to opine on any regulation. Any review should be cognisant of the cost and risk implications on the pensions industry of having lower leveraged LDI strategies.

Given the interdependencies, we would advocate a coordinated discussion and action across the relevant regulatory bodies and industry stakeholders like Cardano.

We note that had additional regulation or monitoring arrangements been in place, they would have been in line with the market environment and therefore it’s unlikely they would have prevented the recent situation which went beyond any reasonable stress test scenario. As such, any additional regulation or monitoring should be thoughtful, taking into account both the unpredictability of market stress events as well as schemes’ objectives to manage their assets coherently with their liabilities whilst reducing the deficit in a risk-controlled manner.

Whether DB schemes had adequate governance arrangements in place. For example, did trustees sufficiently understand the risks involved?

We believe, in general, schemes had adequate governance processes in place for the functioning of leveraged LDI mandates under normal market scenarios and reasonable stress test scenarios i.e. the governance structures and collateral waterfalls were sufficient to replenish collateral levels under an orderly increase in yields (such as that experienced in the first part of 2022).

But the rise in long dated Gilt yields in late September and early October resulted in the speed and size of collateral requirements which went beyond market participants’ risk models and scenario testing and many schemes and market participants were unprepared for such collateral calls.

For reference, we note the chart below, showing rolling 5-day moves in 20-year Gilt yields over the last 10 years.

Source: Cardano, Bloomberg. Rolling 5-day moves are shown for business days only (excluding weekends and public holidays).

The resulting experience was not uniform across the industry. Most schemes had adequate governance in place but there were outliers. Schemes that managed best through this scenario were those with strong advisory or fiduciary arrangements and/or professional trustee relationships and an investment strategy that enabled the liquidity to be redeployed quickly and in a cost effective manner. 

We understand that smaller schemes were most heavily impacted due to challenges accessing the required advice and being more heavily invested in pooled fund arrangements which lacked the faster re-deployment of assets that was needed.

Whether LDI is still essentially ‘fit for purpose’ for use by DB schemes. Are changes needed?

Leveraged LDI strategies provide schemes with the ability to reduce the risk of their assets relative to their liabilities whilst also investing in growth assets to reduce their deficit thus controlling the reliance on the sponsoring company. LDI has therefore been an essential tool for pension schemes to reduce their funding deficit thus providing a more certain outcome for DB savers and reducing the reliance on the sponsoring company.

Cardano has been advising on and managing LDI mandates for schemes since 2000. We have carried out analysis on a subset of our schemes to quantify the impact of using a leveraged LDI solution. We conclude that, without the use of leverage within the LDI strategy, there are schemes where the level of sponsor contributions required would be such to impact the sponsoring companies operating business or be too great for the sponsoring company thus compelling the scheme to the PPF. As such, we believe LDI should continue to be used as a risk management tool for pension schemes.

An example scheme, managed by Cardano since 2008 and with a particularly weak covenant, has been in a position, absent of sponsor contributions, to increase its funding level by over 10% and reduce its deficit by £230m. We estimate that without the use of leverage, hedging only the level of liabilities covered by the physical assets invested in LDI, the funding level would have deteriorated by in excess of 20%. The difference in the deficit between the two strategies is circa £600m. Further, had the scheme not used leveraged LDI, we expect the scheme would have been forced to enter the PPF as the funding level would have been judged to have been unsupportable by the weak sponsor covenant. Today the scheme has a PPF surplus and all pensions have been paid over the last 14 years.

The extreme movement in yields has however exposed a weakness due to the link between leveraged LDI strategies and the vulnerability of the Gilt market, in particular at long maturities where pension fund buying is concentrated. The widespread use of leveraged LDI strategies, in addition to factors such as a large Quantitative Easing programme, has resulted in a Gilt market with reduced liquidity which is therefore more susceptible to market dysfunction.

Any changes should be considered in the context of the benefits of LDI to the pension system and corporate landscape as well as the systematic risks exposed in the Gilt market.

A more robust leverage management system within pension schemes would require high levels of liquidity in the assets used to collateralise the LDI strategy as well as a robust governance model to manage the process.

Should the industry wish to manage the risks associated with the concentration of the Gilt market, the resulting trade-off would be a less leveraged pension scheme system. This will lead to a choice for pension scheme trustees either to increase risk in their pension scheme by reducing their level of liability hedging or to reduce their investments in growth assets such as UK infrastructure. There will be a higher burden on the sponsoring company or, should the burden on the employer become too great, the scheme risks entering the PPF thus impacting DB savers benefits.

We acknowledge the complexity of the situation and any changes in regulation should be thoughtful, being cognisant of the impacts on the security of DB savers benefits, the sponsoring companies and the UK Gilt market.

Does the experience suggest other policy or governance changes needed, for example to DB funding rules?

Please note, our comments in relation to the DB funding rules have been written in regard to this specific inquiry. Wider comments regarding the DB funding rules will be responded to separately in the respective consultations.

A pension scheme’s aim is to have sufficient assets to pay member benefits as they fall due. We therefore agree with the regulatory and policy environment of linking the management of a DB pension scheme assets to these liabilities and believe this should continue.

In respect of levered LDI strategies, we firmly believe these bring major benefits to DB savers and UK corporates, however we note the potential for them to add volatility to the Gilt market in times of stress. It is therefore important that any changes are considered across the different regulatory regimes in relation to the benefits of LDI strategies but also the systemic risks they have brought about.

The DB funding rules are consistent with current regulation and the recent events shouldn’t be a reason to change the rules in isolation. We note that under the proposed new funding rules, if implemented, natural deleveraging of LDI portfolios will occur over time as more assets are moved into bonds/Gilts as a pension scheme matures/becomes better funded. If there are separate regulatory changes resulting from the events, the DB funding rules will need to be reviewed in conjunction with the changes.

November 2022